UK Monetary Policy
- Monetary Policy involves using interest rates and other monetary tools to influence the levels of consumer spending and Aggregate Demand.
- In the UK the target of Monetary policy is to keep inflation within a target of CPI 2% +/-1. They also consider other macroeconomic variables such as growth and unemployment.
- UK Monetary Policy is set by the MPC of the Bank of England. They are independent in setting interest rates, but have to write a letter to chancellor if they fail to keep inflation within the target rate.
During the credit crunch of 2008-09, the Bank of England also used Quantitative Easing as a part of monetary policy. This involves creating money electronically to buy assets (such as government bonds from banks). It is hoped by buying illiquid assets there will be an increase in the money supply and avoid deflationary pressures.
How Monetary Policy Works
The Bank of England study inflationary trends in the economy. This involves looking at a range of economic variables such as:
- Unemployment,
- consumer confidence
- Spare capacity in the economy
- Exchange rate index
- House prices
- Economic Growth
If the Bank of England anticipates inflation falling below the governments target of 2% and economic growth is sluggish or the economy is facing a recession. They are likely to cut interest rates.
Lower interest rates in theory, should stimulate economic activity. This is because lower interest rates reduce borrowing costs. This increases the disposable income of consumers with mortgage interest payments and should encourage spending.
If the Bank feels the economy is growing too quickly and inflation is expected to exceed the governments target, then they are likely to increase interest rates to reduce the rate of growth and inflationary pressures. See: Effects of Raising Interest Rates in the UK
- Blog entries - UK Monetary Policy
Limitations of Monetary Policy
Some limitations of monetary policy include:
- Liquidity Trap - When a cut in interest rates fail to stimulate economic activity. e.g. because of low confidence.
- Difficult to control many objectives with one tool - interest rates. For example, a rise in oil prices causes cost push inflation and lower growth. The Bank could increase interest rates to reduce inflation, but, it would cause economic growth to fall as well.
- Changing interest rates has an effect on the exchange rate
- Interest rates may affect some parts of the economy more than others. e.g. higher interest rates increase the disposable income of people with savings. But, could cause homeowners to be unable to afford their mortgages.
- See also: Limitations of UK monetary Policy
See also:
- Bank of England - Official website of the Bank of England.
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